There is a semi-joke in Ireland that whenever you are asked for directions, the first response should be: “Well, I wouldn’t be starting from here if I were you.” A similar scenario presents itself in the corporate bond market. How do we get to a situation where spreads are justified by credit quality? Well, you don’t start from here – research by Morgan Stanley suggests that the average corporate’s cashflow will have to increase by 20% to make the return embodied by current spreads equivalent to the risks (if compared with 1998 borrowing and spread levels).
The problem with 20% increases in cashflow is they don’t happen without rampant economic growth. And if the economy starts booming again two things are certain – equity prices will pick up and interest rates will be increased, neither of which bodes well for credit.
But neither is likely before the second quarter to second half of next year. So the situation is reminiscent of 1994, when the Economist magazine was warning investors that the NYSE and Nasdaq were overvalued and a bubble was building – it took seven years for that prediction to be proved right.
In credit, any change is also likely to take time: research by Lehman Brothers shows how low issuance today equates to tighter spreads in 12 months’ time. In the more realistic world of credit – a lack of upside and obvious downside – if a bubble is building, at least it will not continue to inflate for the next seven years.